Why China Should Remove All Trade Tariffs

I am a Tariff Man. When people or countries come in to raid the great wealth of our Nation, I want them to pay for the privilege of doing so. It will always be the best way to max out our economic power. We are right now taking in $billions in tariffs. MAKE AMERICA RICH AGAIN

@realDonaldTrump tweet 10:04EST, 4 December 2018

It is widely understood by economists of most theoretical persuasions that trade tariffs are a bad idea, but President Trump has laid out his stall. The political class, prodded usually by the vested interests of crony capitalists, always fall for trade protectionism. President Trump’s tariff war is just the latest example that coincidently stretches back to the introduction of central banks. I shall address this coincidence later in this article.

It also surprising that the Chinese leadership enters a tariff war when it professes to defend free trade. Perhaps it doesn’t fully understand why tariff-free trade matters, and like Trump, thinks that a trade surplus is simply a function of cheaper prices. This misconception confuses how trade balances arise with the profitability from lower costs in foreign jurisdictions. That is a different issue. China would be far better to respond to Trump’s tariffs by removing all theirs, and in effect challenging American corporations to see if they can capture market share in China against local manufacturers and service providers.

What if they can? Well, China’s economy will benefit from obtaining goods and services someone else can provide better, freeing up economic resources for more efficient, appropriate and productive use. The underlying point is tariffs are a tax on both consumption and production inputs which impedes economic development. Tariffs are self-harm. We condemn teenagers self-harming, but not when governments do it.

This article explains why China would benefit enormously from the abolition of its own tariffs, as would any country following tariff-free trade policies. The other side of this coin, escalating tariffs, is the highway to economic ruin. The first step in developing this argument is to remind us of the empirical evidence, the awful damage tariffs did to the global economy following the First World War, and the appalling financial and economic consequences when they culminated in America’s Smoot-Hawley Tariff Act of 1930.

The histories of monetary inflation and tariffs are closely linked

Expansion of both bank credit and the commercial bills market in America in the 1920s were an addition to the monetary and price inflation during the First World War. Despite cumulative monetary expansion, America managed to adhere to an exchangeable gold standard until 1933. Similarly, other countries that returned to a post-war gold standard (such as the United Kingdom) did so at pre-war rates of convertibility on massively expanded bases of circulating money. All had to eventually devalue. Other European currencies had simply collapsed by 1924.

Money supply in the US increased 73% between 1913-1919, and wholesale prices doubled. In the UK, money supply increased by 144% and wholesale prices rose by 157%. It was from these elevated bases that the expansion of circulating money continued through the 1920s. While we tend to recall the economic advances from the spread of electric power and the manufacture of automobiles, we gloss over the substantial monetary imbalances. Monetary imbalances result in price imbalances, leading to politically unwelcome trade and capital flows. Governments and central banks attempt to smother the symptoms, which was the underlying reason behind the cooperation between Benjamin Strong at the Fed and Montague Norman at the Bank of England during that decade.

In the First World War, production output was commandeered by governments, which had the effect of eliminating foreign competition. As international trade resumed in the post-war years, this was no longer the case, and businessmen were faced with foreign competitors whose cost bases were in rapidly depreciating currencies. Naturally, they agitated for tariffs to ring-fence their domestic markets. This led to the Emergency Tariff Act of 1921 in America, consolidated in the Fordney-McCumber Tariff of 1922. Foreign nations responded by increasing their own tariffs, and the contraction in international trade was a significant factor behind the currency collapses suffered by the beginning of 1924 in Austria, Bulgaria, Germany, Greece, Russia and Poland. And because the contraction of trade made it virtually impossible for these countries to pay off war debts to America, the supposed benefits of trade protection came at an enormous capital cost to America itself.

In 1922 US import tariffs ranged from 7% to 68%, averaging 38%. While much of Europe was depressed following the War, by 1926 their economies and employment had recovered despite these tariffs, which had become insufficient protection for American businesses. In 1930, the Smoot-Hawley Tariff Act increased import tariffs across the board to an average of 60%.

Given the history of American businessmen working with politicians towards trade protection, we should not be surprised to see Donald Trump, a businessman-president, reintroduce tariffs to protect American business. His tweeting says everything. His economic illiteracy and political motivation faithfully replicate those of Senator Smoot and Representative Hawley. Furthermore, the unwillingness to learn from history is depressingly familiar, and the outcome has become dismally predictable.

In 1930, the reactions of the US’s trade partners, who followed Smoot-Hawley by increasing their protectionist tariffs as well, were equally predictable and economically illogical. Commodity prices had begun to fall in anticipation of the collapse in trade. This had a devastating effect on US farmers, who had been a core reason behind tariffs in all the debates on trade in Congress, even before the First World War.

The US stockmarket crashed in late-1929 ahead of the first major vote on the Smoot-Hawley Act on 31 October. Traders could see which way it was going, and correctly anticipated the economic effects. Bizarrely, politicians put the stock market collapse down to a lack of business confidence that would be cured by a swift introduction of the Smoot-Hawley Act.

Optimists might argue that the lessons of the 1920-1930s were the first time the negative effects of tariffs became obvious to politicians and the wider public, and therefore are unlikely to be repeated. Not so. In May 1930, a month after Smoot-Hawley was passed by Congress, a petition signed by over a thousand economists asked President Hoover to veto it. Today’s economic establishment is similarly united against tariffs, but if anything, President Trump is less open to persuasion on trade than was President Hoover.

Today, stock markets seem poised on a cliff-edge while America targets China with tariffs. On Monday, there was a one-day relief rally in stockmarkets, reflecting the ninety-day postponement of new US tariffs against China. But stock prices did not hold and have begun what could turn out into a devastating financial panic, replicating the value-destruction on Wall Street in October 1929.

The history of political inanity from ninety years ago suggests the love of tariffs is so deeply imbedded in the political class’s psyche that empirical evidence will be ignored. It insinuates that we are early in a continuing tariff war rather than nearing a settlement, and the economic consequences of trade policy are in danger of tipping us into a repeat of the Great Depression.

We still have the tariff battle between the US and the EU ahead of us. That was put on ice while China was dealt with, and we can be certain that Trump will return to that subject in due course. The EU is itself highly protectionist, and therefore a red rag to Trump’s bull. We can only hope that escalating threats never materialise as action. But that is the hope born from despair. If it is left to politicians, tariffs will more likely only ratchet upwards.

Farming and the money are different this time

There were two significant differences between the 1920-1930 period and now which should be mentioned.

The first was grain and farmland prices were further undermined by overproduction, due to the rapid adoption of mechanisation and new pesticides. The prices of all agricultural produce collapsed, impoverishing farmers around the world. The dust-bowl conditions of the 1930s did the rest to finish off farmers in North America.

The second difference is in the money. The slump in demand for raw materials in the Great Depression led to a collapse in commodity prices, measured in dollars. At the time, so far as the public was concerned, dollars were gold substitutes, being exchangeable for gold at $20.67 to the ounce. Therefore, the collapse in prices reflected an increased purchasing power for gold, and the eventual policy response was to rescind dollar convertibility in 1933 and then to devalue it by 40% the following January.

If we suffer a repeat of the trade-driven slump of the 1930s, it will be measured in the fiat currencies of today. At the least, we know central banks will offset any tendency for falling prices by inflating the money supply. That is already official policy. Monetary inflation will not resolve the underlying problems, only serving to conceal them. Central banks will attempt to achieve a Blondin-like wire-walking balance between the money quantity and price stability. This cannot be managed without raising both interest rates and the cost of borrowing for governments, and we must therefore conclude that a tariff-driven economic slump will threaten to undermine the dollar and all fiat currencies linked to it.

Why trade imbalances have nothing to do with prices

It is time to address the theory behind trade imbalances. We have seen the empirical evidence, that politicians are easily persuaded the excess of imports over exports is due to unfair competition. Even American corporations tend to locate their manufacturing in the cheapest locations to maximise their profits, and they will often close their operations in more expensive locations to reduce costs. This has riled President Trump when he complains about trade deficits. But the reason for trade imbalances has nothing to do with unpatriotic behaviour or price competition. It is endemic to fiat currencies.

We can deduce that in a sound-money regime, that is to say one where payments are accepted in gold or fully-backed gold substitutes, trade imbalances can only be minor and temporary, because imports have to be paid for with inflexible real money, earned so it can be subsequently spent. Money and credit cannot be produced out of thin air to pay for imports. If a deficit on trade does arise, gold flows out and consequently domestic prices for goods will fall. Communities with higher prices will tend to buy from communities with the lower prices, and manufacturers will tend to sell to communities with higher prices.

In this way, gold flowing between communities evens out each community’s preferences for gold relative to goods, and therefore both trade and prices self-adjust towards a common level.

Armed with this certain knowledge, we can proceed to describe how trade imbalances arise in a fiat money regime. They depend on the relative rates of expansion of money and credit between one currency and another, because trade imbalances still have to be paid for, but always in today’s flexible, fiat money. This leads to the following identity in national income accounting:

In other words, a trade deficit is the net result of a shortfall in the combination of savings and budget deficits. More correctly it applies to both capital and goods without distinction and is captured in balance of payments (BOP) statistics. This is an important point, given the large quantities of money circulating within the global financial system that are not associated with trade settlements.

Assuming we are considering a country with a BOP deficit, a shortfall of savings for investment is always made up by an expansion of money and bank credit. If capital inflows from abroad are involved, they will result in either the currency being provided by the central bank, or by an origination through prior or active expansion of bank credit. In any event, the central bank stands ready to ensure there is no net drain on money-markets through its management of both interest rates and its own balance sheet.

Therefore, it is clear that under all circumstances the savings shortfall in the national accounting identity above must be made up by monetary expansion.

Similarly, a budget shortfall can only lead to an expansion of money supply, usually involving the issuance of treasury bills or similar short-term instruments. When government bonds are issued, banks subscribe utilising their balance sheets. When non-financial entities and savers buy government bonds, they either divert net savings from private-sector investment (which is made good by monetary expansion as described above), or they increase their savings by reducing consumption. Reducing personal consumption in favour of saving requires higher interest rates, which are prevented by liquidity injections by the central bank.

Furthermore, having raised funds, the government spends it, putting money back in public circulation. If it has drawn on savings, those savings are turned into government spending. If not, purchasers of government bonds have only one recourse, and that is to draw on monetary or credit expansion. Therefore, whichever way you look at it, a budget deficit expands the money quantity.

A similar analysis applies to a nation with a BOP surplus. In this case, monetary expansion is less than the increase in savings, which is then reflected in a BOP surplus. Therefore, when considering trade imbalances, prices have nothing to do with it. Prices will only influence the source of supply, not the demand for it.

Defining the origin of trade imbalances through the framework of national accounting is confirmed by looking at it from a different aspect. The division of labour tells us we make things and provide services in order to earn the money to buy the other things we need and to accumulate some savings. This is still true when we are the breadwinners in a family of others who do not work for money. It is also true of money earned and passed to others through charities and the agency of government. Unemployment benefits and welfare payments have to be earned by someone.

This describes an economy where sound money is the temporary agent for converting production into consumption. Now let us assume that more money is introduced into the economy, not earned by anyone as described above, but produced out of thin air. Consequently, more money begins to chase the same quantity of goods.

Naturally, the introduction of extra money will push up domestic prices. For a period of time imported goods will remain available at the old prices. The supply of these goods must come from countries less affected by inflation-fuelled demand. In practice, other countries inflate their currencies as well, so price differentials become a relative matter. Furthermore, some nations’ citizens habitually save more than others, and so long as the volume of their savings increases relative to their money supply, there will be goods and services available for export to other communities.

Ignoring the true source of trade imbalances was a major flaw in Keynesian economics, leading to a myriad of other problems. The adoption of unsound money to cover budget and savings deficits is at the heart of it all. It is therefore no coincidence that these imbalances have increased hand-in-hand with the power of central banks. It seems extraordinary that despite some basic incontestable economic theory, Keynes envisaged doing away with savers altogether and for the state to provide the entrepreneurs with cheap capital. In this, Keynes was clearly a mathematician without a fundamental grasp of his own subject, otherwise he would not have denied the truth in the mathematical identity above. Instead, he decided to rubbish Say’s law, which defined the division of labour, and then ignore the consequences of the state management of economic outcomes with unsound money.

The benefits of free trade

It must be obvious in the light of reasoned economic theory that China is making a bad mistake by responding to Trump’s self-harm by self-harming as well. It’s not even worth getting into a dialog with madness, because all it encourages is more madness. Instead, China should remove all tariffs and let her consumers and businesses compete freely with foreigners.

It was perhaps a radical idea, first promoted in Britain by David Ricardo, who demonstrated the benefits of comparative advantage (1817), then taken up by the Anti-Corn Law League with Richard Cobden and John Bright (1836-38). They persuaded Robert Peel, the Prime Minister at the time, of the merits of free trade. The result was the repeal of the Corn Laws (1846) making tariff-free trade the national policy in Britain thereafter.

Consequently, Britain became the most powerful nation on the planet, despite its small size. Before the First World War, fully 80% of all shipping afloat had been built in Britain, with the Clyde, Belfast and the Tyne major shipbuilding centres. Britain did benefit from assembling an Empire with which to trade, but at the heart of this success was free trade.

The Chinese should take note. They will have also witnessed the remarkable successes of Hong Kong and Singapore, following the Japanese surrender in 1945. Their success was entirely due to free markets enjoying tariff-free trade driven by their own diasporas, while governments declined to intervene. It is therefore illogical for China to play Trump at his game.

Far better to let him destroy America’s potential through wrong-headed tariffs, exemplified by Trump’s tweet at the head of this article.

After all, in the great game of geopolitics, through the destruction her enemies visit on themselves and by avoiding the same mistakes lies China’s quickest and most certain route to rapidly raising the living standards and wealth of her own people.